National Institute of Economic and Social Research

Tuesday, 13 March 2012

Why rising gilt rates would be good news

[updated 8am 14 March with additional section on QE, at end]

According to the FT (£) the Chancellor plans to issue an “Osborne bond” – a 100-year debt issue or even a perpetual gilt that never matures – to "to lock in the benefits of Britain’s low borrowing costs, which he claims reflect market confidence in his fiscal plans."

This plan makes perfect sense from the taxpayer perspective - if the markets are prepared to lend us money for nothing (in real terms) we should be biting their hands off. As Martin Wolf has said, the markets are saying "borrow and spend, please". Borrowing more, long-term, at low interest rates, to finance the infrastructure spending the UK needs - while creating jobs and generating growth - is exactly what the economy needs right now.

But this opportunity - the current level of long term interest rates - does not reflect "market confidence." Both economic theory and the empirical evidence suggest that the current level of long-term interest rates is primarily the result of economic weakness, not strength.

When long-term interest rates do start to rise - as they will at some point - it will be good news; reflecting the fact that finally a sustained economic recovery is beginning to take hold. At that point, anyone who has bought an "Osborne bond" will see a large capital loss. I don't normally give investment advice; but unless you think that government policies really are condemning us to a Japan-style lost decade (or ten) - and I'm not that pessimistic - I'd give it a miss. First, some theory. What determines the level of long term interest rates on government debt? The standard neo-classical view is that, as the Bank of England puts it in its handybeginners guide to monetary policy, "long-term interest rates are influenced by an average of current and expected future short-term rates".

In
other words, theory suggests that the low level of long-term interest rates in the UK reflects low expected future short-term rates. And what determines expected future short term rates? Again, the Bank of England is quite clear on this - expected inflation. And why does the Bank expect inflation to fall sharply in 2012 and perhaps beyond? Because the economy is weak. The most recent set of minutes from the Bank's Monetary Policy Committee is very clear on this:

"Against this background, and that of its most recent projections to be published in the February Inflation Report, the Committee judged that the weak near-term outlook for growth and the associated downward pressure from slack in the economy meant that, without further monetary stimulus, it was more likely than not that inflation would undershoot the 2% target in the medium term."

So what underlies the Treasury's contention that low interest rates reflect "market confidence"? It is, of course, true that reduced default risk should lead to lower interest rates on government debt, just as it should on any other debt. But, as I have pointed out before, there is not and has never been any significant default risk on UK government debt. Nor is there any obvious evidence that movements in interest rates have been related to changes in market perceptions of default risk. As I predicted at the time, Moody's recent decision to put the UK's rating on negative watch had precisely no impact on market interest rates.

Obviously, if we believed the Chancellor, the main thing driving interest rates would be the deficit, and in particular market expectations of the deficit going forward. Conveniently, the Treasury publishes a summary of external forecasts of the economy. These forecasts change over time, and here is the average of external forecasts for the deficit in 2013-14, plotted against ten year gilt yields.

Higher deficits lead to higher interest rates? Not exactly. If anything, the opposite, certainly over the last year - because, of course, both higher deficits and lower interest rates are driven by economic weakness, precisely as theory predicts.

And there is an even clearer test of the evidence. As well as looking at long-term interest rates, we can also look at stock prices. Stock prices are positively correlated with market perceptions of economic strength. Those perceptions may be and often are wrong - but in general stock prices will go up when market participants become more optimistic about economic prospects, and down when they become more pessimistic.

So what does the evidence show? For the last two years, the data shows that the correlation between changes in long term interest rates (ten year gilt yields) and changes in the FTSE 100 index is strong, significant and positive. In other words, when investors became less
optimistic about the UK economy, gilt yields fell. The falls in gilt yields
were associated not with greater confidence or optimism, as the government has
argued, but the reverse. Low long-term interest rates are largely the result of persistent economic weakness. That's what the theory tells us, and that's what the data say.

Finally, some cause for optimism, although understandably the government is not trumpeting it too loudly. Since January - the nadir of economic pessimism - long-term interest rates have risen, not by much, but noticeably. This has gone in tandem with rather better economic news - for example, NIESR's monthly GDP estimate last week suggested the economy is unlikely to shrink in the first quarter, as many had feared. When we do see evidence of a strong and sustained recovery, interest rates will rise - and that will be good news. Unless, of course, you bought an Osborne bond.

[ADDED 8AM MARCH 14]

Fraser Nelson (who has also blogged on this here) correctly points out that I should also have mentioned the impact of quantitative easing (QE) on gilt yields. Although the methodology is hardly robust, the Bank of England estimates that the immediate impact of the initial round of QE was a reduction of 1 percentage point in gilt yields. More broadly, as both the article and the MPC minutes make clear, QE, exactly like ultra-low short-term interest rates, is the Bank's policy response to economic weakness and the possibility that inflation may fall below the target. So, to the extent that low gilt yields are the result of QE, this is again about economic weakness much more than "market confidence".

Moreover, at some point - when the economic news is better - the Bank intends to sell the gilts it has bought under QE back into the market. It is very difficult indeed to say ex ante what impact this will have on gilt yields, but it would be surprising if it did not push them up somewhat; another reason why rising yields will eventually go hand in hand with economic recovery.